The seismic decision by the United Kingdom to exit the European Union continues to shake up global markets. After plunging 610 points on Friday, the Dow Jones Industrial Average dropped another 260 points on Monday. All of which may be tempting investors to make their own exit from the stock market.
Resist the urge. Making a dramatic shift in your investments in the midst of a market crisis is unlikely to end well. If you have a well-diversified portfolio—one that is geared to your goals and risk tolerance—you're probably better off staying put. In any case, you should avoid overreacting to the fears of the moment. To help you take a more measured view of today's global turmoil, here are four rules to keep in mind based on behavioral finance research.
Following forecasts is folly.
"My lodestar is the knowledge that no one can forecast the future, especially six months to one year out," says investment adviser William Bernstein, author of The Four Pillars of Investing. There's no better recent example than the Brexit vote itself, which most forecasters expected would affirm Britain's continued membership in the European Union. Looking over longer periods, Wharton professor Philip Tetlock has found that most expert forecasters are wrong far more often than they are right.
Why are so many forecasters so wrong? One key reason is overconfidence. Studies have shown that many people overestimate their ability to invest, which leads them to trade more often, to their detriment.
Another behavioral mistake is hindsight bias, which leads people to believe, when looking back at an event, that they "knew it would happen." That only encourages future misunderstandings about the probability of forecasting the future and the likely outcomes of events. This isn't just true for so-called experts—average investors are equally likely to mistake their beliefs for reality.
Think back to prepare for the future.
Fear of losses is one of the biggest drivers of investing behavior, and it's also one that leads to big mistakes. That's because the pain of losing money far outweighs the pleasure of profits, as Nobel-prize-winning research by Daniel Kahneman and Amos Tversky proved. That fear typically leads investors to remain too conservative in their investments or to sell when they see the market falling.
Getting a bit of historical perspective can go a long way toward alleviating panic, however. Think back to how you reacted during the depths of the 2008-2009 financial crisis. Anyone who bailed out of stocks back then missed out on one of the biggest and longest bull market rallies in U.S. history—since early 2009, the S&P has climbed 172%. "Instead of fear of loss today, think about the risk of future loss by not being in the market, " says Hal Hershfield, assistant professor at UCLA Anderson School of Management.
Those future losses are likely to far outweigh any short-term drop in your portfolio. According to calculations by J.P. Morgan, if you were invested in the S&P 500 between 1996 and 2015, you would have earned an average annual 8.2% return. But if you missed the 10 best days, your return would be only 4.5%. Six of the 10 best days, by the way, occurred within two weeks of the 10 worst days. And for the truly risk averse, if you stayed out of stocks for a month after big market declines, your average annual return drops to zero.
Opt for a self-driving portfolio
A great way stay on course is to automate your portfolio, which insulates your money from any tendencies to make poor decisions. By funneling regular contributions from your paycheck into a target-date fund, balanced portfolio, or some other kind of managed account, you can be assured that your asset mix will be rebalanced automatically, which ensures that you'll be buying stocks low when the market drops and selling high when prices rebound. Most crucially, automation will also take the decision-making out of your hands, which will ensure that you stick to your plan.
Studies have shown that, on average, managed accounts tend to deliver similar or even better returns than do-it-yourself investors, but with far less dispersion in returns—a narrower range of highs and lows, in other words. Sure, you may not shoot out the lights, but you're less likely to suffer huge losses.
Consider a cool-down period.
For those who prefer a do-it-yourself investing approach, consider setting up your own guardrails. Make a commitment never to act until at least 10 days after developing an investment idea. By that point, the market may have moved on to other concerns, and you may have, too. After all, most investors have already forgotten the big market slides in January, which occasioned plenty of panic at the time.
If you're still tempted to sell, "ask yourself, 'who's the fool on the other wide of the trade?'" says behavioral finance expert Meir Statman of Santa Clara University. Sure, the buyer may be a misguided speculator, but just as likely it's someone in the know who has better information than you do, Statman says.
Or take a lesson from Warren Buffett, who prefers to buy quality stocks when they're selling at a discount and holding for the long term. For the rest of us, who may not match his skills, just holding on is the next best thing.